COVER STORY, MAY 2010

MAXIMIZING RETURN ON LAND INVESTMENT
By Stephen Schattner

When considering a land investment, the investor is faced with imperfect information. Interested parties must compare the attributes of a targeted property to all other land investment opportunities in the area and be able to quantify and relate this data to measurements such as price and size.

The evaluation of these attributes on a comparative basis impacts the prediction of current price. A proportion of variability in the data will measure how likely future outcomes are by not only the quality and quantity of the data, but also by what data is selected in the evaluation of the pricing model. This gives the investor a true gauge of market value. This is accomplished by evaluating thousands of properties and then conducting non-linear regression analysis to determine the validity of the data.

Once the data is deemed valid, an investor can project forward the demographic growth models of an area. This helps determine the development cycle. It also forecasts the inflation-adjusted price for improvement and disposition value for a multitude of land investment opportunities. The outcome will yield the best land investment opportunity that maximizes the return to the investor. 

When a property is removed from production (agricultural or mineral), the only way an owner can control appreciation is by enhancining value through entitlement and/or development.

Land has four finite life cycles — maturing, selling, developing and liquidating. Each cycle is discussed in depth below.

Maturing

In most cases, when property is acquired, the buyer pays more than the market curve. This premium accounts for the buyer’s demand, closing costs and entitlement expenses, and carry costs. There often is a spread between the purchase price and market value.

As the market matures and as the entitlement process creates intrinsic value, market value will eventually converge with the purchase price. Market value and purchase price eventually intersect the asset’s minimum compounding return of comparable risk. During this time, a sale value below the value paid will result in financial loss. A sale immediately following acquisition for less than the asset’s minimum compounding return of comparable risk will result in a Stage-1 economic loss.

The maturing cycle of land recently removed from agricultural production is often lengthy — 2 to 5 years or more — and encompasses issues such as regional wastewater extensions, population growth resulting from municipal system expansion, flood recovery, zoning, economic incentive negotiations and more. The timing of investment must force an investor to consider what is not happening now during economic turbulence, but several years from now.

Selling

Up to the point of maximum profitability, the ideal land investment business strategy is to sell the property. This is the least risk to the investors with maximum reward potential. Imposing additional investment risk (development) should only be considered after the declining rate of the market curve begins to erode the investor’s profitability.

Risk factors that will dictate the development risk premium must be determined to justify development. By the time maximum profitability has occurred, Imperium Law assumes there is little more that the property owner can do to create value through entitlement and inflation is static. However, constant assessments must be made to determine if inflation is increasing (or deflation is eroding) the value of the property. During increased rates of market inflation, the value of property will take a step up in market value,  increase the opportunities for enhanced profitability, and extend the date of Stage-2 economic loss.

Inflation can occur at any time — even after Stage-2 economic losses have occurred — bringing the inflation-adjusted market value back into economic profitability. It is important to note that inflation does not account for increased or variable investor return considerations due to inflation. Eventually, without value enhancements such as development, the market value will converge with the asset’s minimum compounding return of comparable risk, creating, once again, the potential for Stage-2 economic losses.

Developing 

Development changes the risk profile from the original investment intent. Therefore, the asset’s minimum compounding return of comparable risk will shift upward once development is initiated. A development strategy should be sought for one of two reasons: the maximum profit potential for the land has been attained without any sales activity, or there is an incremental increase in profitability less the incremental increase in the asset’s risk-adjusted minimum compounding return of comparable risk. The second option is not a consideration in Imperium Law, since the initial intended investment is to hold land for long term appreciation. Development is, however, an exit strategy for the land investor, and should not be considered as a mutually exclusive component of land investment. 

In order for the land investor to maintain static risk exposure, the optimal time to consider development is when the difference between the change in the market curve and the change in the asset’s minimum compounding return of comparable risk is at its height and no sale transaction has occurred. The caveat for development is that the future potential profit with development should meet or exceed the profit of the future potential land sale; this is always the multi-million-dollar business plan gamble with land investments at this stage of the life cycle.

There is no way to determine future values or timing of sales to suggest that the development option will be a better business decision.  Additionally, the risks involved with development are too numerous to be discussed. There is comfort to the investor that once significant time has transpired, the development option becomes very apparent.

Liquidating

Imperium’s brokers and principals have come across sellers that believe they can “hold out” and their property will infinitely rise in value. This falsehood is the basis of the Imperium Law of Land’s Diminishing Return. It often occurs when a land owner, non-sophisticated in daily activities of commercial real estate, believes he can play the role of “developer” or “broker” and can create more value on his own. This business plan results in failure and missed opportunity, often causing tenants to bypass a seller’s property.

During Imperium’s discussions with thousands of land owners, and when encountering unsophisticated “hold out” owners, Imperium has never seen a seller that has successfully implemented a development or sales business strategy. At the convergence of the asset’s minimum compounding return of comparable risk with market risk, an investor will be better off divesting the asset and investing in another asset of comparable or exceeding returns that has comparable risk.

As time progresses, the incremental increase in price does not adjust at the same rate as when the market was maturing. This is due to supply-demand economics. There are only so many grocery stores, drug stores, and fuel stations that a community of any size can support until it reaches saturation. In theory, proper urban planning should prevent this from occurring, but no such example exists or can account for the dynamics of economics combined with local politics and consumer behavior.

Unfortunately, almost all communities have embraced a “more is better” approach in an attempt to increase their probability of luring commercial development to their community (commercial sales tax offsets the burden of residents’ property tax for basic social services.) This results in large, oversized commercial tracts at every intersection. Second-tier buyers ultimately enter the area seeking to capture a proven market, but due to market saturation that erodes sales, they are unable to justify paying market rates that were previously seen by land owners during a maturing market.  As second-tier buyers enter the market, the perceived quality of the immediate market deteriorates and has a compounding diminishing impact on the price of land. Therefore, the rate of increasing land prices slows. 

Land owners will face a difficult decision, many of whom have had property in their family for generations: to sell or to hold. Land is an investment asset that has no sentimental value. Liquidation should always occur when the asset has reached and exceeded Stage-2 economic breakeven and when other investment opportunities exist that are of equal risk with greater upside potential.

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